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February 07, 2012

Crowdfunding to Raise Capital for Real Estate Investments. Good Idea or Bad?

The following is a guest blog from syndicating expert, Gene Trowbridge. His contact information is at the bottom of this post and if you would like to hear my interview of Gene in which we discuss recent developments in real estate syndication, click here.

Crowdfunding is a hot, new term that is being used to describe a method where a real estate syndicator could use social media on the Internet to raise small amounts of money from large numbers of investors.

Last year two people used this approach to raise over $200MM dollars from over 5 million investors, only to be issued a cease-and-desist order from the SEC for having raised money without registering their offering and violating the prohibition against advertising and solicitation in an unregistered offering.

Currently the general rule is that every offering of a security must be registered with the SEC, unless exempt. Most commercial real estate syndicators try to take advantage of the exemption available through Regulation D, Rules 504, 505 and 506. Each of these rules prohibits the issuer from making an offer through advertising or solicitation, which covers making offers on the Internet.

The House of Representatives passed H.R. 2930 which authorizes the Entrepreneur Access to Capital Act. If passed by the Senate and signed into law by the President, this Act would create a new exemption from the requirement to register the sale of a security with the SEC providing that:

· The total amount of securities sold by an issuer in a 12 month period does not exceed $1MM, or $2MM if the issuer provides audited financial statements to the potential investors; and

· The aggregate value of securities sold by an issuer to any individual investor does not exceed the lessor of $10,000 or 10 percent of the investor’s annual income.

This Act does not place a limit on the number of investors, does not prohibit advertising and general solicitation and does not require extensive disclosure be made to investors. However, the issuer must:

1. Put a warning on their website that the investment is speculative and illiquid;

2. Warn investors that there are restrictions on the resale of these securities;

3. Not provide investment advice to investors;

4. Have each investor complete an offering questionnaire that will show that the investor understands the level of risk involved in the security being offered;

5. State the amount of money to be raised and have a third party hold the funds until 60% of the stated amount has been raised; and

6. Outsource cash management to a qualified third party, like a registered broker or dealer.

While this legislation proceeds through the process to what might be eventual implementation there are several drawbacks that we see for its use by commercial or residential real estate syndicators in their fund. The major ones would be:

· The limitation of the $1MM funding limit, as audited financials rarely exists;

· The management of large number of small investors, each with a maximum of $10,000 invested;

· The requirement that a broker dealer will be involved in the cash management of the fund; and

· The requirement that the SEC issue rules and regulations that will inevitable be structured under their primary purpose of protecting unsophisticated and non-accredited investors.

This proposal appears to me to lead to results that are opposite of the goal of the SEC, namely, allowing large numbers of inexperienced investors to invest in small untested companies with a minimum of disclosure and almost no supervision.

I will keep you informed as this legislation moves to passage or oblivion.

Don’t forget to go to www.groupsponsor.com to see about our gift MP3, our workshops and self-study course, and my book about real estate syndication “It’s a Whole New Business” orwww.syndicationlawyers.com to learn about our law firm.

Joel, I agree with you. I don't see that changing the laws will make people smarter or protect people anymore than what the current laws do, except maybe clarify the law some. A sophisticated promoter should know that there is something wrong with crowd-sourcing or just doesn't care. There are hucksters and there are hucksters and I don't think that will ever change.

It is correct that Crowd Funding is making it's way through the legislative process, but even if it is passed in a format that is attractive to promoters, most promoters lack the internet marketing skills to adequately and appropriately find and sell to investors.

Most early stage promoters think that if they meet an investor, that the person will be so enamored with the deal that the money will appear. Not so. Raising capital is an art form that requires 3 critical phases: 1) the promoter has to position him or herself as an expert in the assets being acquired; 2) an investment structure and deal has to be presented that the investor finds attractive; and 3) the promoter or syndicator has to feel good about the compensation they will receive for the deal - in other words, great balance has to be found.

Short of these 3 elements, money won't move. I wonder if the legislation will really help most would-be syndicators. If you can't raise money now, what makes one think that a law change will make it much easier? The hard part is getting a prospect to say "yes" and even with the new rules, that part stays the same. Plus, wealthier people are much easier to deal with in the long run. The new rules may make it even more expensive to do syndication business in the future.